Underwriting Your PIP by William G. Sipple

Ask any hotelier about their experiences with financing and you’ll likely get a mixed-bag of answers, but most will point out that hotels remain one of the hardest asset classes to capitalize. To complicate matters, a number of the branding companies have recently announced either renewed efforts to bring lagging properties up to current standards, or new standards programs intended to differentiate their brands from the pack. As a result, many hotel owners today face major capital expenditures or risk losing their brand affiliation, which potentially triggers a default under their existing financing. Typically, there are a couple of common situations that we come across in our investment banking practice.

First, unless an owner is regularly in the debt markets, he or she may not know that their property may now qualify for low-cost fixed-rate financing that would cover part or all of the PIP. HVS Capital Corp has financed a number of projects lately that fit into this very category. In fact, a number of owners have approached us with the intention of selling their asset. However, after analyzing the deal, the “sale” turned into a financing that allowed them to keep their hotel, avoid a taxable event, and retain much of the cash flow from the project. The reality is, in this aggressive funding market, cash flowing assets that sell at a high single-digit cap rate may be able to reap financing proceeds at a 10 to 11 debt yield. Many factors play into this type of scenario, including strength of sponsorship, potential for exit for the lender, barriers to entry for new hotels in the market, and last-dollar-in basis for the senior debt holder. This may allow enough capital for the owner to complete the property upgrades and finance the majority of the costs at low, senior mortgage rates on a non-recourse basis.

In the other instance, despite the recent surge in debt available for hotels, financings for properties just outside the lender’s typical strike zone could be difficult to execute. Even in markets where RevPAR has shown substantial increases, many properties are just getting back to adequate coverage ratios on their debt. There just isn’t enough room between the existing debt levels and the property’s value to insert new debt and still service the loans. These situations call for more creativity in assembling the capital stack.

The clearest approach is to explore various recapitalization options that allow for the funding of the PIP, unless there has been a permanent change at the property or marketplace, which precludes underwriting a future improvement. There are various financing sources that offer creative solutions to franchisees, allowing them to recapitalize their hotel assets even when there is insufficient trailing-twelve month’s income to cover current debt service on the new structure. Properties with improving income and reasonable chances for turnaround given capital investment are also viable candidates. That a hotel’s asset quality has declined, or that it is not in a primary market, are factors that can be overcome.

Until recently, many senior lenders did not allow subordinated leverage as an option. This has changed in the past year and now, given the right circumstances, owners can utilize this tool to increase proceeds beyond a typical senior lender’s underwriting benchmarks. This potentially allows the owner to complete a much-needed renovation. The subordinated leverage is generally structured as a mezzanine loan secured by a pledge of ownership.

The majority of active institutions in this space are amenable to structuring their position behind an existing mortgage, as long as appropriate risk-related financial terms can be negotiated and there is sufficient term remaining. The lender for the new subordinated leverage will require the loan to be co-terminus with the maturity of the senior mortgage. A common challenge is to negotiate an acceptable inter creditor agreement, but many providers of senior and subordinate debt have regular parties with whom they partner on structured transactions. A last potential issue is that many existing senior mortgages preclude additional indebtedness. Nonetheless, if these hurdles can be overcome, this may be an ideal solution for borrowers facing an imminent PIP requirement. The cost of the subordinate debt capital tranche can range from 12% to 20%, but the overall blended cost with a newly issued or an existing senior mortgage, will typically be acceptable.

The more likely solution in today’s low-cost-of-capital market is a new senior/mezzanine combination that takes advantage of current favorable terms. A recent example of a transaction we completed involved a 300+ room, full-service, branded hotel requiring about $8 million in renovations. There were serious supply growth constraints in the market and the property had a very good “upside story” supporting the projected lift in NOI. We were able to combine a low-cost, non-recourse senior mortgage with a mezzanine component that both cleared the existing debt and allowed for reserving the full amount of the renovation cost. The last dollar in reflected an aggressive 8 debt yield. The potential for upside in the property and market assured the subordinate lender that their debt yield would be more in the 10 to 11 range in short order. The other option for the borrower was a sale at approximately the same proceeds as the combined debt. For good reason, they were believers in their ability to move the hotel forward and decided to retain ownership.

So whether you are facing a mandated product improvement program, or just want to capitalize on an opportunity to take a project up-market, there are creative ways to leverage your plan that will safely enhance equity yields at the same time. Each individual situation and set of objectives is unique, and it’s rare to find a transaction that has no challenges. It’s good to know that in today’s environment, there are a number of options available.

About William G. Sipple

William is executive managing director of HVS Capital Corp (HVSCC), where he leads a team of professionals that provide a wide range of real estate investment services on an international level. HVSCC is the investment banking arm for HVS, and has extensive experience in debt and equity raises, asset sales, and capital structuring. You can contact Bill at (303) 512-1226 or wsipple@hvs.com. His “Inside Financing” column will appear regularly on LodgingMagazine.com.